Sequestration and the Economy: What Does This Mean for Investors?

If you`ve been watching the news, you`ve probably heard a lot about "sequestration." We understand that many of our clients are concerned about the effect of these spending cuts on the economy and their financial future. We are reaching out to provide some information and reassurance.

Sequestration refers to the $85 billion in automatic federal government spending cuts that are scheduled to begin March 1.

A Brief Background

The Budget Control Act of 2011 established caps on federal spending designed to reduce the national debt and established a new debt ceiling, which is the federal government`s borrowing limit. The U.S. hit its borrowing limit on December 31, 2012. If lawmakers were unable to agree on deficit reduction measures and raise the debt ceiling, sequestration would kick in on January 1, 2013 and institute mandatory federal spending cuts across all aspects of governmental operations. These cuts formed part of the "fiscal cliff" debates in late 2012, and the American Tax Relief Act of 2012 reduced the size of the sequestration from $109 billion to $85 billion and postponed the deadline until March 1.[1

In order to pay the government`s bills, the Treasury has implemented temporary measures. In order to resolve the situation and avoid sequestration, Congress and the White House must agree to either raise the debt ceiling or adopt measures to reduce spending or increase revenue. Otherwise, the U.S. risks defaulting on some of its financial commitments.

Sequestration and the Economy

Sequestration would not be catastrophic for the large and robust American economy. However, these automatic spending cuts would cause major disruptions to government activities and cut payments to government-funded organizations (many of whom are in the defense sector). Worse, the cuts are arbitrary and widespread, meaning that agency heads are unable to pick and choose where to trim spending.

While the total economic cost of sequestration is unknowable at this point, some economists estimate that sequestration would contribute to the loss of 700,000 jobs (including drawdowns in the armed forces) and shave 0.6% off of GDP this year.[2]

While this may seem like a small cost to pay, slower growth, increased unemployment, and reduced consumer confidence may drag out the economic recovery even longer.

What Does This Mean for Investors?

If the sequestration deadline arrives without Congressional action, we expect a period of market volatility will follow. Markets are already reacting nervously to the prospect of spending cuts and a potential U.S. default on its debt obligations. However, we do not believe that default is likely and, even if the spending cuts hit, lawmakers will strike a deal when they begin to feel the pain of sequestration.

With respect to long-term investing, sequestration is simply a bump in the road. In December, all anyone could talk about was the fiscal cliff and how badly markets would be affected. However, as of February 22, 2013, the Dow has gained 6.84% since the beginning of the year.[3]

As financial advisors, we focus on building long-term wealth for our clients. While short-term market movements may provoke anxiety, we have learned to seek out opportunities in many market conditions; good and bad.

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